The history of American business is rich with stories of redemption and perseverance. For decades, no stars shined brighter than AIG (AIG) under the leadership of Hank Greenberg, but in the course of just a few months, the company was left for dead. Few CEOs have impressed me more than Robert Benmosche, who stood up to the government, for the purpose of being able to rebuild the business so that taxpayers could be repaid for providing what equated to debtor in possession financing to the company. AIG has executed on that repayment and so much more, but the pervasive environment of negativity pertaining to financial companies, and the blame game for years gone by continues to mask what I would argue is one of the great restructurings in American business history. While AIG's stock continues to trend higher, there is a long runway to go with a very large margin of safety, and the company remains my top investment opportunity.
Over my early career as an investor and portfolio manager, I've often found myself wondering why other market participants didn't see value when it seemed so apparent to me. Then at some point, I just stopped caring about others' opinions about stocks and when the facts told me that I was right I found myself willing to bet big, as in the words of Buffett, "it only takes a few great opportunities over the course of a life time to become very rich." AIG was one of the two most research intensive ideas of my lifetime, but the facts of the situation made the inherent undervaluation of the stock extremely apparent. As other stocks have appreciated, thereby decreasing the margin of safety, I've continued to shift assets towards AIG, making it the biggest investment in my career. I believe the company's discount to book value will eventually dissipate, but I believe that there is a longer-term opportunity that AIG's inherent distribution and scale advantages could potentially position the company to out-earn its cost of capital, leading the way for substantial l! ong-term gains far beyond anything we have seen thus far with the stock. The story is far from over, and I could still end up with serious egg on my face, but until the facts tell me I am wrong, I will continue to buy more AIG stock as opportunities come about.
On May 2nd, AIG reported net income attributable to AIG of $2.2 billion and after-tax operating income of $2.0 billion for the quarter. This was down from last year but the 1st quarter of 2012 had over $3 billion of pretax gains related to non-core holdings, which distorted GAAP earnings. Diluted earnings per share attributable to AIG and after-tax operating income per share attributable to AIG were $1.49 and $1.34, respectively. Insurance operating income of $3.0 billion was up 28% YoY. AIG's year-end risk-based capital ratios were 443% for Property Casualty and 532% for Life and Retirement, meaning the company has ample room to increase premium growth or dividend payments to the parent depending on opportunities that present themselves moving forward.
As of March 31, 2013, AIG's shareholders' equity totaled $99.5 billion. In the quarter, AIG called $1.1 billion of junior subordinated debentures. The company also purchased approximately $1.0 billion in principal debt for approximately $1.3 billion, which will result in $165MM in annual interest savings. AIG's Life and Retirement subsidiary paid AIG's holding company $1.3 billion in dividends and loan repayments in the quarter. AIG's Parent liquidity sources amounted to approximately $15.0 billion at March 31, 2013, including $5.5 billion that is allocated toward future maturities of liabilities and contingent liquidity stress needs of the Direct Investment book and Global Capital Markets. AIG also completed the purchase of warrants issued to the United States Department of the Treasury in 2008 and 2009, which will eliminate the potential dilution these securities could have caused. The Parent company has expenses of about $2 billion a year, and will be further bolstered by a targeted! $4.5-$5 ! billion of dividends from the subsidiaries, and the proceeds from the ILFC sale. AIG will likely be designated a SIFI so I think it is smart to be conservative in estimates of returns of capital to shareholders, but it is very apparent that AIG is likely to emerge significantly overcapitalized in any common sense analysis.
AIG Property Casualty had a very strong quarter with operating income of $1.6 billion, up from operating income of $1.0 billion at the same time last year, reflecting increases in both underwriting income and net investment income. AIG is fully-focused on improving underwriting margins, which have lagged behind peers over the last five years. In the quarter, the combined ratio was 97.3, compared to 102.1 last year. The results were bolstered due to the unit only incurring $41MM of catastrophe losses, which were more than offset by $52MM of net prior year development. CEO Robert Benmosche knows that analysts have doubted the reserving policies of AIG for some time, so changes in prior year developments will be an important metric to monitor, and AIG has already added substantially to reserves to fix this problem moving forward.
The accident year loss ratio for the quarter, as adjusted, improved to 63.2 from 66.3 YoY. This was largely driven by the units shift to higher value business, enhanced risk selection, and price increases. The 1st quarter acquisition ratio was 19.7, which was down .5% YoY, while the general operating expense ratio rose .4% to 14.3%. Net premium written growth was 4% excluding the impact of reinsurance agreements and foreign exchange. Commercial insurance rates increased 4.2% overall and 7.4% in the United States. U.S. Property and U.S. Workers' Compensation led the way with 8.9% and 8.3% increases, respectively. The company continues to invest in strategic initiatives such as improving its IT and data-based infrastructure. The idea is to optimize AIG's immense amount of historical underwriting information by using big-data to become more efficient in! underwri! ting new business. If AIG continues to underwrite at a combined ratio less than 100, the earnings leverage for the overall company is immense, and when interest rates improve, a ROE of 15% could be a reality, but only time will tell if the company can consistently execute. The company is making an effort to do more direct marketing, which will have a negative impact on the combined ratio, but will have a positive impact on ROE over the lifetime of the business generated. I believe this is an important development that AIG should have emphasized a decade or more ago, but AIG's brand is very powerful and direct marketing should ultimately lead to margin expansion if executed soundly.
AIG Life and Retirement reported operating income of $1.4 billion in the quarter, up from $1.3 billion at the same time last year. Buoyant equity markets drove investment returns, while strong growth in assets under management increased earnings in the fee based businesses. AIG also benefited from continued active management of spreads and lower mortality costs. Net investment income was $2.9 billion in the quarter, flat with last year, even though in 2012 the results included $246MM of Maiden Lane II fair value gains. Low interest rates continue to have a very negative impact for all insurers, and AIG is no exception with its base investment yield in the quarter falling to 5.3%, from 5.5% in the 1st quarter of 2012. Assets under management increased 12% to $297 billion at the end of the 1st quarter, compared to $265 billion last year at the same time. I would like to see AIG continue to build its mutual fund business, which I believe could increase returns on equity for the division due to the low capital requirements. Premiums and deposits totaled $5.6 billion in the 1st quarter of 2013, which was flat from 2012. Variable annuity deposits increased 31% to $1.4 billion, while fixed annuity deposits decreased by 36% to $376MM. AIG Life and Retirement has begun breaking down its results between Retail and Institutional. ! The Retai! l segment reported quarterly operating income of $821MM, which was up 8% YoY, while the Institutional segment had operating income of $573MM, up 4% YoY.
An improving housing and mortgage market continues to bolster United Guaranty Corporation (UGC). The mortgage guaranty unit reported operating income of $41MM for the 1st quarter, compared to operating income of $8MM at the same time last year. Net premiums written were $246MM in the quarter, up strongly from $191MM in the 1st quarter of 2012. Credit quality continues to be very strong with an average FICO score of 757 and an average loan-to-value ratio of 90% on new business. The overall delinquency rate on domestic first-lien loans fell to 7.9% in the 1st quarter of 2013, which was down significantly from 11.4% in the 1st quarter of 2012.
AIG's financial condition continues to improve materially with each passing quarter. The company's book value per share, excluding accumulated other comprehensive income (AOCI), was $59.39 at the end of the quarter, which was up 12% YoY. Book value per share grew 16.87% YoY to $67.41, helped by the impact of retained earnings, and stock buybacks done at a discount to book value. Robert Benmosche laid out a plan to attain a 10% ROE by 2015, but I believe the company is on track to meet this goal more quickly than anticipated. In the 1st quarter of 2013, AIG's ROE and ROE excluding AOCI, were 8.9% and 10.2%, respectively. Very few P&C companies are likely to earn a 15% ROE with interest rates so incredibly low, but AIG has huge pent-up earnings power that will shine through as the improved underwriting filters through future earnings releases. It is important to note that AIG excludes its deferred tax assets in this calculation, which would peg normalized earnings at less than $5 per share in 2015. I believe management is setting a low-hurdle rate that will likely be exceeded, but either way I'd expect the stock to go higher, and ultimately the earnings power is far higher than that.
AIG is focuse! d on redu! cing its net interest costs and improving its coverage ratios through building stronger earnings. AIG ended the 1st quarter with a debt to capital ratio of 18.7%, with 6% of that being hybrid-debt securities. I don't believe that the company will meaningfully reduce that ratio, which is pretty normal for an insurer, but instead I believe that it will continue redeeming the higher cost debt to lower the overall interest costs. AIG has $750MM in callable hybrids with a coupon on 6.45%, which I'd expect to see the company exercise, which could potentially reduce annual interest expenses by almost $50MM. Clearly, earnings have some positive momentum and if we don't have a horrible year for catastrophes, the coverage ratios should be much improved by the end of 2013. AIG is still on track to divest ILFC later in the year, which would indirectly take about $25 billion of debt off of the balance sheet. The company cited that it is spending about $35MM a quarter in reshaping its IT infrastructure that should be done at some point in 2014, so it is not hard to find opportunities to increase returns.
After these goals, Benmosche has mentioned that the next priority is a dividend. I respectfully disagree with the notion that AIG needs to appeal to a broader group of investors, as stock buybacks done at a deep discount to intrinsic value are far more accretive than paying a dividend. Berkshire Hathaway (BRK.B) is a perfect example of a company that has traded at a fine valuation despite not paying a dividend, and AIG would not be doing its shareholders a favor by going the dividend route over stock buybacks at anything close to current prices. Stock buybacks make a lot of sense from a capital management standpoint in that they are easier to halt or terminate in case of a rough catastrophe year or something like that.
AIG ended the 1st quarter with 1.4767 billion diluted shares outstanding, so at a recent price of $44.52, the company has a market capitalization of $65.74 billion. When you look at in exce! ss of $15! billion in parent holding cash that will be bolstered with the sale of ILFC, the undervaluation becomes even more apparent. AIG will not be paying taxes in the United States for quite some time due to its huge net operating loss carry-forwards, so pretax earnings will largely equate to cash. There is no reason AIG can't execute like Travelers (TRV) or Berkshire's insurance operations, but only time will tell. The truth is that at current prices, the company only needs to be average to produce solid returns for stockholders because the price is so low relative to intrinsic value. This strong margin of safety, fantastic upside potential and management that I trust and admire is what has made AIG my biggest investment, and I'm excited to see where that leads in the future.
Disclosure: I am long AIG, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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